First Gorton explains that basically all banking crises work the same way: too many investors want to withdraw their deposits from the banks which cannot cover all of the withdrawals. This type of crises is probably as old as banks themselves. Banks lend out a certain percentage of deposits, so if there is a panic, not everyone can get their money back. This financial crises is similar, but less tangible, because it involves an unregulated banking system used by institutional investors and not average individuals.

The Repo market has been growing steadily for the past 30 years. It is basically an unregulated market where institutions can deposit and borrow money outside of the normal banking system. Because there is no FDIC for this market, deposits are backed by collateral, which is how most US banks worked pre-1930. This collateral is longer term, secure investments such as bonds and other securities.

Why is there demand for such a market? As Gorton explains it, imagine you are an institutional investor and you need a secure short-term (overnight) interest-gaining deposit for $100 million. You cannot deposit this at the local bank, FDIC will only cover $100k, so you must go to another banking system. Now imagine you are a bank with mortgages trickling in cash. You can package these mortgages and sell them to add immediate cash to your bottom line. These securities can then be used by as collateral for a Repo deposit. Both parties have benefited from the Repo market and it has been growing accordingly, but because it is so unregulated, no one really knows how large it became! Estimates are at around $12T, which means there should be at least that much in collateral for it to function properly. To give you an example of how large that is, the entire US GDP for 2009 was $14.2T.

This is where the subprime mortgages come in. While subprimes are a small percentage of the total mortgage-security market ($1.2T out of $20T total), no one knew which securities were contaminated by them. Gorton compares this to an E. coli scare where all ground beef is shunned even though only a small percentage is actually contaminated. The Repo market became the target of a panic because the collateral used for deposits became suspect. There was a run on Repo banks which could not possibly honor all of the withdrawals (he estimates a deficit of $2T). The US Government was forced to step-in and bail out some of the crippled banks while many others simply failed.

So while this crisis may seem extraordinary at first, when compared with the history of banking it can bee seen as the same old story repeating itself. There is much more detail and references in the paper, including some nice graphs, so check it out.

It appears to consistently grow at an exponential rate. Remember this is a logarithmic graph, so exponential growth is represented as a straight line. This is growth of about 6% per year over 68 years. If you invested $1000 in 1950, that would be worth about $50,000 today. If you kept on adding $1000 per year, you would have nearly $1 million. That’s simply the magic of compounding interest.

Complex dynamic systems, like the stock market, can often be described by fractals. One attribute of fractals is that they are self-similar, that is if you zoom in on one part of a fractal, it often appears similar to the whole image. The same phenomenon happens with coastlines and plants for example, but more about that in other post.

Anyway, when a non-trivial period of time does not follow this basic growth rate, people begin to ask why. Take, for example, this chart of the S&P 500 of the past 12 months:

Some features of this chart appear to resemble the 68 year chart above, except for one glaring exception: it appears upside down! A long investor sees this chart and they cry themselves to sleep :0 . In this chart the growth rate is a dismal -40%.

When this happens, investors look for people who predicted such a huge divergence from the trend. One predictor, getting such attention right now, is the famous economist Robert Shiller. In 2000, he wrote the book Irrational Exuberance, where he explained why he believed the stock market was overvalued. One of his main statistical weapon of choice, is called the P/E 10 (or Shiller P/E). It is a chart of price-to-earnings ratios, but earnings are averaged over the previous 10 years instead of the usual 1 year. Here is a chart from James Hamilton’s economics blog:

On average, when the market has a P/E of greater than 20, it means generally that prices will fall and/or earnings will rise. Conversely, when the P/E 10 is less than 10, it means generally that prices will rise and/or earnings will fall. The historical P/E 10 average is 16.3 (the red line in the chart), while the current P/E 10 is 14. This measure demonstrates that the market is reasonably valued.

Hindsight is 20/20, so is this chart actually predictive? Well, we’ll have to wait and see, but the idea behind it is there are times when the market is over-valued and times when it is under-valued. This seems logical, but according to the Efficient-Market Hypothesis, this will never happen because the market defines the value. Shiller is an economic behaviorist, and believes the market is not efficient but rather based largely on psychological factors which are not entirely logical. To me, both positions seem to make sense, and I intuitively feel (I’m sure naively) that there is common ground with these two perspectives. (My basic idea has to do with the relativity of value by individual investors and specifically their time-frame in which they must sell the equity.)

One last interesting fact about the P/E 10: it is difficult to find! You cannot go to any financial site and pull up the P/E 10 for a given index or equity. In fact the chart above was built from Shiller’s own data in Excel format which he thankfully distributes on his site!

It’s hard to look at this and deny the inverse relationship between the P/E 10 and future earnings. Currently we’re smack-in-the-middle of the x-axis, and you can see how future returns along the vertical appears random. Just a few years ago we would have been on the right-side of the chart, leading to the conclusion that returns would likely decline.

A couple of posts ago I asked whether leading researchers in fields besides physics actively debate on blogs. Well the answer is a resounding “YES,” and one example I recently came across is an active debate between world-class economists on causes of the Great Depression. Even recent Nobel Prize winner Paul Krugman gets involved! What I find so surprising about this is they were debating the core concepts of one of the most important events in 20th century economics based on what seemed to be philosophical grounds: whether they were “Keynesians” or “Monetarists.” This also somewhat corresponds to the political parties of Democrats and Republicans respectively.

The basic debate is whether it is better for wealth to be controlled by public (Keynesians) or private (Monetarists) entities. On these blogs the disagreement is whether Keynesian policies caused the depression or brought the country out of it. The fact that there is still no consensus by experts on the causes of the Great Depression is especially troubling at the present time since we appear to be entering a serious recession.

I believe the main problem is that it is difficult to experimentally test macro-economic theories, so economists are left to follow their philosophies. We can only hope that in the future there will be ways to actually test theories, because otherwise is it really a science?

UPDATE: In one week, Greg Mankiw defends Keynsian policies during this recession, and he takes Krugman to task for using philophy instead of a metric! He appears to be the good exception to the rule, by not letting his polical views interfere with his analysis.